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Growth stocks have been outperforming their value counterparts for quite some time now. Rapidly expanding technology companies have been at the forefront of this trend, but we think it could be starting to reverse, at least partly.

There has been recent evidence to suggest that some large investors share our view. According to an article in the Financial Times and research from analytics firm S3 Partners, of the 20 “most shorted” stocks (taking a short position in a stock essentially means betting against an increase in that company’s share price) in the U.S., ten are from the technology sector. This information comes almost in tandem with the setback suffered by shares in U.S. tech companies in early August. Could change be on the way?

Have the FANGs lost their bite?

It’s unsurprising that value, as an equity investment style, has underperformed over the last decade. A backdrop of lukewarm global economic performance and plenty of free-flowing cash from central banks put growth firmly in vogue. The U.S. technology sector was a particular beneficiary of this trend, as investors sought out companies that were undergoing reliable structural growth and exhibiting low volatility. In 2015, the FANGs (Facebook, Amazon, Netflix and Google) lit up the NASDAQ, drawing plenty of media attention in the process. That year, the Dow Jones Industrial Average, which famously consists of the biggest, most stable companies in the U.S., returned just 0.21% in dollar terms. In contrast, the NASDAQ, full to the brim with tech companies, gained 9.8%. The FANGs, meanwhile, averaged an 83% increase over the year, and Netflix was the top-performing company overall on the S&P 500 Index, a wider measure of U.S. blue-chip companies’ performance.

Somewhat inconveniently in acronym terms, the FANGs have now become the FAAAs. Netflix, always an outsider in the group given its comparatively tiny market capitalization (currently around $79 billion compared with, say, Amazon’s $492 billion) was dropped in favor of Alibaba, the Chinese e-commerce company, which is listed in the U.S. And Google became known as Alphabet in listing terms, after it announced the latter would be the name of its holding company. The technology sector’s performance was disappointing in 2016 (Alphabet’s A shares, for example, returned just 1.9%), but picked up once again in early 2017. Indeed, a handful of tech stocks have been responsible for about a third of the S&P 500 Index’s gains so far this year. We believe that such narrow market leadership is worrying; with so few stocks responsible for so much of the market’s performance, it seems positive investor sentiment towards growth investment, and the technology sector in particular, is becoming excessive.

Growth is a crowded house

We think U.S. growth stocks look very expensive relative to the amount of profits they produce. These inflated prices mean that the difference in price-to-earnings (P/E) ratios between growth and value stocks is at a multi-year high. In addition, earnings expectations for some economically sensitive sectors such as industrials are catching up with those for technology companies.

The difference in P/E ratios between growth and value stocks is at a multi-year high:

Source: Thomson Reuters DataStream, August 2017

We think U.S. growth stocks look very expensive relative to the amount of profits they produce.

As of yet, however, this convergence has not created a stampede into value stocks. Investors are continuing to crowd into what they believe to be safe, structural winners – qualities often associated with leading technology and internet companies. In fact, according to a recent survey from Merrill Lynch, being “long NASDAQ” (or holding a higher proportion of growth stocks, in other words) is the most crowded trade of the moment. These stocks are the darlings of Wall Street and mostly command “buy” ratings from research analysts. More value-oriented parts of the market, such as industrials, energy and materials, look vacant in comparison, but this may be about to change. Earnings in these so-called cyclical areas have been depressed for a considerable length of time and are therefore expected to benefit disproportionately from the broadening of U.S. economic growth – they have more room for recovery than their growth-inclined peers. Additionally, growth stocks’ popularity is closely tied (almost by definition) to expectations for their future profits. But the present values of these companies’ cash flows are at the mercy of interest rates, which are likely to increase as global growth broadens and the U.S. Federal Reserve tightens monetary policy. This will likely put pressure on equity valuations, revealing vulnerabilities and, in particular, making growth-oriented companies look expensive compared to their estimated future earnings capabilities.

A long-term view

One of Warren Buffett’s many edicts on the subject of value investing is that investors should simply “…buy shares in a great business for less than the business is intrinsically worth.” The Oracle of Omaha’s view contrasts sharply with that of quant investors, whose “momentum” strategies (or buying of “hot” stocks) have been responsible for the majority of tech stocks’ outperformance this year. According to JP Morgan, passive and quant investors now account for 60% of equity assets and – in a world of abundant liquidity – the hunt for stocks that offer low volatility and stable growth has caused prices to skyrocket. However, if underlying qualities eventually prevail, it may leave expensive growth stocks vulnerable to the law of gravity.

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